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Economics of Taxation


Throughout history, every organized society had some form of government. In free societies, the goals of government have been to protect individual freedoms and to promote the well-being of society as a whole. 

To meet their expenses, government need income, called "revenue," which it raises through taxes. In our country, governments levy several different types of taxes on individuals and businesses. The Federal Government relies mainly on income taxes for its revenue. State governments depend on both income and sales taxes. Most county and city governments use property taxes to raise their revenue.

Government Services

Our American economy is based on the free enterprise system. Consumers are free to decide how to spend or invest their time and money. The goal of producers is to make profits by satisfying consumer demand. Open competition among producers usually results in their providing the best quality of goods or services at the lowest possible prices.

The free enterprise system does not produce all the services needed by society. Some services are more efficiently provided when government agencies plan and administer them. Two good examples are national defense and state or local police protection. Everyone benefits from these services, and the most practical way to pay for them is through taxes, instead of a system of service fees. Other examples are the management of our natural resources, such as our water supply or publicly-owned land, and the construction of hospitals or highways. Taxes are collected to pay for planning these services and to finance construction or maintenance. Revenue is also collected through user fees, such as at the entrances to national parks or at toll booths on highways and bridges.

Society benefits from a safe and healthy environment. In the free enterprise system, however, there is often little incentive for businesses to pay the extra cost for maintaining this kind of environment. Therefore government imposes regulations on producers such as auto manufacturers, who must install air pollution controls. These controls often add costs to the price of new cars. There are also regulations to control such things as the use of billboards and signs along highways. Other regulations control reclaiming land after strip mining, dumping industrial waste into streams and rivers, and noise pollution at airports.

The free enterprise system is based on competition among businesses. With competition, only the most efficient businesses survive. To ensure that a degree of competition exists, the Federal Government enforces strict "antitrust" laws to prevent anyone from gaining monopoly control over a market.

Some services, known as "natural monopolies," are more efficiently provided when there is competition. The best-known examples are the utility companies, which provide water, natural gas, and electricity for home and business use. Since there is no competition, government agencies carefully regulate the services, prices, and profits of the utility companies.

The free enterprise system assumes that consumers are knowledgeable about the quality or safety of what they buy. However, in our modern society, it is often impossible for consumers to make informed choices. For public protection, government agencies at the Federal, State, and local levels issue and enforce regulations. There are regulations to cover the quality and safety of such things as home construction, cars, and electrical appliances. There are also regulations for financial services provided by banks, insurance companies, and stock brokers. Another important form of consumer protection is the use of licenses to prevent unqualified people from working in certain fields, such as medicine or the building trades.

Our children receive their education mainly at public expense. City and county governments have the primary responsibility for elementary and secondary education. Most states support colleges and universities. The Federal Government supports education through grants to states for elementary, secondary, and vocational education. Federal grants used for conducting research are an important source of money for colleges and universities.

Since the 1930s, the Federal Government has been providing income or services, often called a "safety net," for those in need. Major programs include health services for the elderly and financial aid for the disabled and unemployed. Other major programs include financial aid to families with dependent children, and social services for low income individuals and families.

Taxes in the United States

Governments pay for these services through revenue obtained by taxing three economic bases: income, consumption and wealth. The Federal Government taxes income as its main source of revenue. State governments use taxes on income and consumption, while local governments rely almost entirely on taxing property and wealth.


Taxes on Income

The earnings of both individuals and corporations are subject to income taxes. Most of the Federal Government's revenue comes from income taxes. The personal income tax produces about five times as much revenue as the corporate income tax.

Not all income tax taxed in the same way. For example, taxpayers owning stock in a corporation and then selling it at a gain or loss must report it on a special schedule. This item and any other gains or losses get calculated separately before they get added to other income. By comparison, the interest they earn on money in a regular savings account gets included with wages, salaries and other "ordinary" income. There are also many types of tax-exempt and tax-deferred savings plans available that impact on people's taxes.

Payroll taxes are an important source of revenue for the Federal Government. Employers are responsible for paying these taxes, which include social security insurance and unemployment compensation. Employees also pay into the social security program through money withheld from their paychecks. Some state governments also use payroll taxes to pay for the state's unemployment compensation programs.

Over the years, the amount paid in social security taxes has greatly increased. This is because there are fewer workers paying into the system for each retired person now receiving benefits. Today, some workers pay more social security tax than income tax.


Taxes on Consumption

The most important taxes on consumption are sales and excise taxes. Sales taxes usually get paid on such things as cars, clothing and movie tickets. Sales taxes are an important source of revenue for most states and some large cities and counties. The tax rate varies from state to state, and the list of taxable goods or services also varies from one state to the next.

Excise taxes, sometimes called "luxury taxes," are used by both state and Federal Governments. Examples of items subject to Federal excise taxes are heavy tires, fishing equipment, airplane tickets, gasoline, beer and liquor, firearms, and cigarettes.

The objective of excise taxation is to place the burden of paying the tax on the consumer. A good example of this use of excise taxes is the gasoline excise tax. Governments use the revenue from this tax to build and maintain highways, bridges, and mass transit systems. Only people who purchase gasoline -- who use the highways -- pay the tax.

Some items get taxed to discourage their use. This applies to excise taxes on alcohol and tobacco. Excise taxes are also used during a war or national emergency. By raising the cost of scarce items, the government can reduce the demand for these items.


Taxes on Property and Wealth

The property tax is local government's main source of revenue. Most localities tax private homes, land, and business property based on the property's value. Usually, the taxes get paid monthly along with the mortgage payment. The one who holds the mortgage, such as a bank, holds the money in an "escrow" account. Payments then get made for the property owner.

Some state and local governments also impose taxes on the value of certain types of "personal" property. Examples of personal property often taxed are cars, boats, recreational vehicles, and livestock.

Property taxes account for more than three-fourths of the revenue raised through taxes on wealth. Other taxes imposed on wealth include inheritance, estate, and gift taxes.

The Federal Income Tax

A basic principle underlying the income tax laws of the United States is that people should be taxed according to their "ability to pay." Taxpayers with the same total income may not have the same ability to pay. Those with high medical bills, mortgage interest payments, or other allowable expenses can subtract these amounts as "itemized deductions" to reduce their taxable incomes. Similarly, taxpayers may subtract a certain amount on their tax returns for each allowable "exemption." By lowering one's taxable income, these exemptions and deductions support the basic principle of taxing according to ability to pay.

Those with high taxable incomes pay a larger percentage of their income in taxes. This percentage is the "tax rate." Since those with higher taxable incomes pay a higher percentage, the Federal income tax is a "progressive" tax.

Sales and excise taxes, by comparison, are considered "regressive." Since the goods get taxed at the same percentage, those with lower incomes pay a larger percentage of their income in sales and excise taxes. Federal income taxes are collected on a "pay-as-you-go" withholding system. Most employers must withhold taxes from their employees' paychecks and send the money for deposit into the General Fund of the Treasury. Self-employed individuals and businesses must pay their taxes in regular installments, known as estimated tax payments. Paying taxes through withholding or estimated taxes during the year helps reduce the government's expense for borrowing money. It also provides an easier method for taxpayers to pay their taxes. To keep collection costs down, the Internal Revenue Service expects all taxpayers to comply with the law voluntarily. Most taxpayers figure out how much tax they are supposed to pay and file their income tax return by the date it is due. Without this voluntary compliance, it would cost the Internal Revenue Service a great deal more to collect the same amount of revenue.

Your Federal Dollar

The Federal Government operates on a fiscal year that begins on October 1 and ends on September 30. Most of the Federal Government's revenue comes from personal income taxes. Other sources of revenue include social security and other insurance taxes and contributions, corporate income taxes, excise taxes.

Federal receipts are spent on many programs. Among the largest are social security and Medicare. Another large portion of Federal spending is for national defense, and includes pensions for retired military personnel and defense-related atomic energy activities.

Another major government expenditure is net interest, or interest payments on the public debt less interest received by trust funds and other interest the government receives. The Federal Government borrows money by selling Treasury securities (bills, notes and bonds), United States Savings Bonds, and other securities.

Income security programs, including unemployment compensation, retirement and disability programs, and benefits such as food stamps and housing subsidies, also come from Federal Government revenues. Also, the Federal Government spends money on health care, including assistance for the poor through the Medicaid program, the training of health care professionals, and medical research activities.

Programs for education also get funded by Federal revenues. These programs include education, training and social services such as grants to elementary, secondary, and vocational schools and assistance to colleges and universities. Also included in this category are grants made to state for social services programs.

Veterans and their dependents also receive benefits from the Federal Government. This included pensions, medical services, education training, and life insurance programs.

Transportation is another spending category and includes grants to states and local government for constructing highways, mass transit systems, and airports. Also included in this category are the costs of operating the Coast Guard, regulation of the airways, and assistance to railroads and shipping.

There are many other Federal Government services and activities, including protection of natural resources, environmental protection, and maintenance of recreation areas and public lands. In addition, there is assistance to foreign countries, disaster relief and community and regional development. Other government services are energy research, development, and conservation, and space exploration and other scientific research. The Government must pay for its administrative activities, along with Federal law enforcement and Federal prisons, payments to the Postal Service, aid to small businesses, and mortgage financing insurance. Finally, the Government provides funds for crop subsidies, agricultural research, and conservation of farmland.

Last Updated: 12/5/2010 10:27 AM